Factors That Affect Effectiveness of Forward Guidance

The "forwards guidance" has been he FED's one of the novel tools to boost the economy after the recession at the zero lower bound. Forward guidance is the FED's public statement on how it will change or unchange the federal funds rate. We can see the latest forward guidance statement from the FED's January statement:

Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

Essentially, what the FED tries to achieve by such statements is to guide the market expectation of the interest rate. The FED has been using forward guidance to lower the market expectation of interest rate during the period it stated.

I should explain two types of forward guidance as introduced by Campbell et al. (2012). Odyssean type of forward guidance is when the FED commits to low interest rate policy even after the economic condition raises the natural interest rate above zero, and Delphic forward guidance is when the FED publicly forecasts its monetary policy's shape regarding the future shocks in the economy. We can see that the FED has been pursuing the Odyssean forward guidance since September 2012 because it publicly stated then that the the low interest rate policy would stay even after the economy strengthens:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

Having talked the basics of the forward guidance, we should study further what factors play a role in effective forward guidance program. First, the FED's credibility decides whether the forward guidance will achieve its goal of lowering the market expectation of interest rate.If the market doesn't believe in the FED's plan for the future interest rate, the forward guidance cannot stimulate the economy as the FED hopes. After all, what the forward guidance's mechanism bases on is the FED's policymakers' hope that the market will take the FED's statement on the future of the monetary policy as granted. Reports are coming in saying that the FED has lost its credibility since the FED is no way raising the federal funds rate even though the unemployment rate is very likely to reach 6.5% very soon. I can understand why this might distort the FED's credibility. If we look at the FED's October meeting's press statement, following statement follows the same statement in the January statement above. October's statement reads:

 ...In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.

But in December, the FED added one more statement following the above statement. The added statement follows:

...The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.

From this change in the forward guidance, one can say that the FED didn't follow what it forward guided previously. But to me, I don't see any credibility problem for the FED. Didn't the FED literally say in the above statement that it will more likely to extend the low interest rate even past the time unemployment rate drops below 6.5%? Didn't the FED have to modify its stand on its future interest rate policy according to the economics condition? Therefore, seeing the FED as not committing to its forward guided policy is like saying the FED has one chance to state what the interest rate will be in the next few years, and if it doesn't follow that, we cannot believe in the FED.

Rather, I think the FED faces credibility problem when it suddenly increases the interest rate when the unemployment rate lowers to 6.5% because current forward guidance tells us that the FED will very likely be pursuing near zero interest rate even after the unemployment rate hits the threshold.

Second factor that determines the effectiveness of the forward guidance is the public's forecast of the recovery. If the public believes that the economy will soon recover, then the public naturally expects a higher interest rate in the future. In that case, when the FED successfully forward guides its low interest rate policy, the consumption and investment will increase because the FED has just lowered the public's interest rate expectation. Hence, the firms and households are more likely to consume and invest more. On the other hand, if the public expects the economy to be still recovering from the recession in the future, it expects the interest rate to be lower as it is now. In that case, even the FED forward guides the economy by promising the persistence of low interest rate, the public's decision on consumption and investment isn't affected that much since its interest rate expectation isn't changed.

The working paper by Gavin et al.(December 2013) concludes following:

The stronger the expected recovery, the more households believe the future nominal interest rate will rise and the larger the stimulative effect of forward guidance on current consumption. We find that news of a −50 basis point shock to the nominal interest rate next period leads to an increase in current consumption of about 0.20 percent.

In summing up the discussion, I believe the FED's current forward guidance policy's stimulative effect is still ambiguous considering the FED's mixed signals on the economic outlook through its bond buying program tapering, which gives the market positive sign, and its reluctance to increase the interest rate even though the unemployment rate is almost at the threshold, which might worry the market. Interesting news to follow in next few months will be the FED's next change in its forward guidance program.

PS. Should the FED and Mrs. Yellen not-forward guide the public as the Chicago Bulls and Derrick Rose do?

Thought on Forward Guidance: Proposal for the Fed

The FED has been pursuing its so called "forward guidance" program hoping it could stimulate economy by convincing the persistence of low interest rate policy. It stated that it sees the current low interest rate appropriate as long as the unemployment rate remains above 6.5% and the expected inflation in one to two years is below 2.5%. According to the statement, it will consider the broader labor indicators and inflation expectations to decide how long it will continue the near zero interest rate policy once the unemployment rate drops to 6.5%. Therefore, it is very up in the air when the FED is increasing the federal funds rate.

We know that the latest report shows the unemployment rate is 6.6%.  This rate indicates that even though the monthly net number of jobs added hasn't been up to the projections for last two months, the FED will soon be deciding its future policy and writing up its well-into-future forward guidance once the unemployment rate hits 6.5%.

After all, the FED's low interest rate policy has been directed toward increasing investment. But there could be different type of "forward guidance" that could potentially create more investment as the FED wishes. My proposal to the FED is that:

a) It should forward guide the market by putting hard deadline on when it is increasing the federal funds rate and therefore the market interest rates. How this clear deadline for increase in federal funds rate works is following: If the FED successfully (!) convince the market that it will indeed push up the federal funds rate, the investors will have clear expectation of when the overall market interest rates are rising. Therefore, realizing the higher investment cost in the specific future, firms will have incentive to borrow and invest today before the FED raises the interest rate. Hence, the investment could increase as the FED has been wishing. This argument is analogical to the people's consumption when there is very high inflation expectation. If the expected inflation is very high, people would try to buy goods as soon as possible. But the one difference between these two analogies is we don't know what interest rate is very high to be analogy to the high inflation rate.

One might say that then if there is higher demand for loanable funds because of this policy, the interest rate will rise in the loanable funds market. But we have to remember, the FED has control over overall interest rate in the economy (or I believe so), it will pursue its current near zero interest rate policy until the date it forward guided comes.

b) Again, to succeed in increasing investment, the FED must be able convince the market that it is indeed increasing the federal funds rate at that certain date, To convince the market, the FED should set the date to be in near future and interest rate minimally higher in first few periods and commit to what it said.

According to latest report, the expectation of the FED's federal funds rate in June 2015 has lowered in a recent month. This might be showing that the FED's forward guidance indeed successfully convinced the market that the FED will be pursuing near zero interest rate policy. If current forward guidance is indeed somewhat successful, I believe the proposed forward guidance could be also successful.

Remember, at the time when the FED sets the specific date to increase the interest rate, the interest rate will be still zero percent, therefore there will be no negative shock to the total investment.

The problem to implement this forward guidance is that the FED cannot surely know how bad or good the economy will be performing at the time of its forward guided date. The FED could announce its first date to increase the interest rate once the unemployment rate reaches 6.5%. If the FED chooses 3 months to increase the federal funds rate after the unemployment reaches 6.5%, it can study how the investment behaved during this 3 months when the market believes the increase in the interest rate is coming. If the sign turns out to be good, the FED can further implement this "hard deadline for minimal increase in federal funds rate" forward guidance.